Avoiding tax on liquidating distributions of partnership property through timing of distributions.

• Author: Ellentuck, Albert B.

Editor's note: This case study has been adapted from PPC Tax Planning Guide--Closely Held Corporations, 17th Edition, by James A. Keller, William D. Klein, Sara S. McMurrian and Linda A. Markwood, published by Practitioners Publishing Company, Ft. Worth, TX, 2003 ((800) 323-8724; www.ppcnet.com).

Facts: Mary and Michelle are equal partners in Ma Belle, an accrual-basis general partnership. Early in 2003, they decided to liquidate the partnership. At the beginning of 2003, Ma Belle's assets were:

Adjusted Basis Fair market value Cash $ 50,000 $ 50,000 Accounts 30,000 25,000 Fixed assets 30,000 200,000 Total $150,000 $275,000 The partners anticipate $25,000 of the receivables will be collected before the end of 2003; the balance will be uncollectible. They plan to distribute all the fixed assets in kind as soon as possible. (None of the partnership's noncash assets were contributed by partners, and the fixed assets have no recapture potential.) However, for ease of collection, the partners do not wish to distribute the accounts receivable. They expect the partnership will break even for the portion of 2003 it remains in existence. Each partner has a $75,000 basis in her partnership interest. Issue: How should the partnership's assets be distributed to avoid or minimize tax to the partners?

Analysis

A tax adviser should consider two factors in minimizing or eliminating tax on liquidating distributions to the partners:

1. The timing or ordering of the distributions (i.e., whether to distribute cash or property first).

2. Each partner's individual tax situation.

The ordering of distributions is important; a cash distribution produces gain recognition to the extent it exceeds a partner's basis in his or her partnership interest, according to Sec. 731(a)(1) and Regs. Sec. 1731-1(a)(1). However, a proportionate distribution of property (other than cash or marketable securities treated as money) does not produce taxable income to the recipient, regardless of the basis of the partner's partnership interest. Accordingly, the tax adviser should advise the partners not to distribute the property before the cash. If they do, the property will soak up basis, increasing the likelihood a cash distribution Mil be taxable. If the cash distribution precedes the property distribution or accompanies it as part of the same transaction, the cash will soak up the basis, reducing the potential for gain recognition on the distribution; see Sec. 732(a)(2) and Regs...